Wild Weather

Unpredictable weather conditions can inflict losses on many companies.

To handle this risk, weather dealers offer tailor-made, structured weather insurance and derivative solutions that protect company earnings against weather events. Something is working because weather derivatives have gained a substantial foothold in the last few years, not only as a risk management tool, but also from a trading perspective.

Weather drives a significant amount of the price volatility in the increasingly interdependent range of energy commodities including weather and emission certificates. Supply and demand are key. Changes in expected demand (e.g. seasons that are cooler or warmer than anticipated) and expected supply (e.g. hurricane threats or well freeze-offs) influence prices and price action of energy instruments (options, futures, etc. that are based on energy prices), including natural gas, heating oil, coal, emissions, propane, and hydroelectric power. Similarly, weather events such as heat, drought, and freezing temperatures drive prices in the agriculture sector from the supply side.

During the summer of 2005, fears of another Hurricane Ivan, the huge tropical storm of 2004, focused more attention on the subsequent – and ultimately historic – 2005 hurricane season. The U.S. 2005 tropical storm season saw 26 named storms and set a number of records. It was the first season to have 13 hurricanes, including three Category 5 hurricanes, and was the first to have four major hurricanes hit the United States. This weather was coupled with an extremely hot 2005 summer and one of the coldest starts ever to the December 2005 heating season.

These factors helped drive energy prices to record highs, followed by a sharp sell-off in natural gas when the predicted cold winter in 2005 did not materialize in the U.S. Similarly, but not as dramatically, price run-ups in the agriculture sector occurred because of the record heat and drought in the corn and soybean belt in late June and July 2005.

WEATHER DERIVATIVES

A weather derivative is a transaction through which payments from one party to another are made based on weather-related measurements typically provided by a national weather service or, in the case of Chicago Mercantile Exchange (CME) contracts, by MDA Federal/EarthSatellite Corporation. From a risk management perspective, weather derivatives allow corporations to transfer a well-defined portion of their weather-induced profit volatility to a third party.

Volumes on the CME have exploded this year: commodity traders are recognizing opportunities to optimize profits through cross-commodity trading strategies, including weather contracts.

The notional value of CME weather contracts has grown from US$2.2 billion in 2004 to more than US$36 billion through 2005.

The customer base is still predominantly comprised of energy companies, but the market appears to be expanding. Today, customers include golf courses concerned with too much rain, municipalities bracing for too much snow, and ski resorts or clothiers worried about too little snow.

Weather contract premiums depend on a number of factors, including the future probability of certain weather events occurring for a given period from an historical and actuarial perspective, future forecasts and trends, and the level at which the customer wants protection to begin (deductibles).

VARIETY OF RISK

Weather affects the volume of energy that power companies can sell. It creates volatility in revenues and earnings.

A mild winter reduces natural gas and electric power sales for heating, resulting in volume-related revenue shortfalls for utility and energy companies. Lower-than-normal rainfall reduces power production at hydropower plants, forcing utility companies to run higher-cost power plants. Excessive rain at planting or harvesting times, as well as hot and dry weather during the growing season, will adversely impact agricultural concerns affecting the farmer, the processor, railroads, barges and elevators.

By creating weather indices specifically tailored to client needs, weather derivative dealers provide two types of customized solutions for managing weather risks:

* hedges for pure volume risks based on weather triggers, and

* hedges for volume and price risks based on a combination of weather and energy commodity price triggers.

Parametric weather triggers can be defined on a broad range of weather data, including temperature, precipitation (rain, snow), precipitation-dependent variables (river flow, water levels, etc.), and wind (speed and direction). Most of the weather structures in the weather market have Cooling or Heating Degree Days as an underlying measure.

The best dealers offer both Degree Day structures as well as tailored indices to reduce basis risk. These custom solutions are designed to use the actual revenue shortfall caused by the weather and the clients’ weather hedge by combining weather measures, as well as blending weather and commodity price risk.

IDENTIFYING AND QUANTIFYING RISK

Canada’s energy companies are no strangers to weather risk. Hydro-electric producers, for example, depend on both precipitation and temperature. If the snow pack is plentiful and summer temperatures are cool, both power prices and sales volume may be low. Conversely, if precipitation is low and temperatures hot, the producer may be exposed to buying replacement power at high prices. Weather solutions can protect against both; prudent companies are exploring precipitation as well as temperature covers. If precipitation low, payments for the derivative can be measured by the weather but paid in power.

The weather also affects the Canadian agricultural markets. Low precipitation generally leads to low yields; this affects the producers and grain handlers such as elevators, railroads, barge transportation and processors. The derivatives market in Canada has great potential. Attractive pricing can be found in solutions based on temperature or combined temperature and precipitation. The dominant protection in the weather market lies either with utilities exposed to cool summer (low sales) risk, or with agricultural concerns exposed to risk from heat and dryness. This combination is excellent from a derivative dealer’s perspective. Combining price risk with the weather exposure through quanto products (where the weather measure may trigger a payout in a commodity price) creates even more flexible customer programs.

The use of weather derivatives is moving beyond energy companies, too. Golf courses sell umbrellas for a reason: customers need them if it rains. As golf course managers realize, storms not only cause golfers to stay indoors, but rain also means lost revenue in green fees, refreshments and pro shop purchases. Similarly, prolonged drought leads to excessive irrigation costs and, if accompanied by excessive temperature, to decreased revenues.

The summer of 2005 brought with it severe weather conditions in the U.S., which caused many golf courses to incur large irrigation costs and run the risk of rapidly deteriorating fairways and greens as well as decreased play.

WEATHERING THE RISK

Weather risk affects most industries and may encourage measures to protect a company’s profitability. Weather contracts serve a vital role in hedging risk across many industries. From a portfolio perspective, weather contracts offer one of the best non-correlated return opportunities relative to the traditional debt and equity markets. Weather contracts can also be additive return sources in conjunction with energy and agricultural trading opportunities (in which, for example, new funds integrate weather and commodity trading).

Canada has a promising combination of traits from a derivative point of view. Its agricultural and hydroelectric participants face risks that substantially offset each other — hydro providers are concerned wi
th cool summers, while the agricultural sectors are wary of hot summers. These significant activities could benefit from weather risk management. The prospects are good: as more companies enter the market to trade or hedge their risk, liquidity continues to improve and provides positive reinforcement to new entrants through improved pricing.